Wednesday, October 15, 2014

Don't Panic --- Yet!

Volatility has returned to the stock market and most of the gains of 2014 were wiped out in the last week. Is it time to panic? Not yet!

There is a close relationship between changes in the value of the stock market and changes in the unemployment rate one quarter later. My research here, and here shows that a persistent 10% drop in the real value of the stock market is followed by a persistent 3% increase in the unemployment rate. The important word here is persistent. If the market drops 10% on Tuesday and recovers again a week later, (not an unusual movement in a volatile market), there will be no impact on the real economy. For a market panic to have real effects on Main Street it must be sustained for at least three months. And there is no sign that that is happening: Yet.

It is of course, possible, that movements in the stock market are only apparently causal. In reality, the clever people who trade in the markets are prescient in their ability to foresee the very bad fundamentals that are driving the real economy. It is also possible that sometimes, market participants panic and that panic has real consequences when the rest of us find that our houses and pension plans are suddenly worthless. My own theoretical work supports the latter hypothesis but reasonable people can disagree.

So: should you be worried that we are about to enter a double dip recession? In my view, not yet, because, as of right now, the market shows no signs of a persistent drop when measured in real terms. When (and if) the Yellen Fed follows through with its withdrawal of QE; we may be looking at a very different situation. Hang on to your hats!

"If the only concern were to get the economy back on track, then the fastest way to get things moving would be to send a check for $2,700 to every U.S. resident. If the administration were worried about the distribution of income, this check could be counted as taxable income, thereby requiring high earners to pay some of it back. A family of four would receive $10,800, and it is likely that much of that money would be spent immediately on goods and services. This way of increasing aggregate demand would be immediate, and it could be as large as needed. It has the advantage that the money would stay in the hands of households and would not create a large new government program. Would it work? Administration economists think so."